We’re getting into the performance of the economy and financial markets in the third quarter and provide our outlook on expectations for the fourth quarter and early 2022.
We break down key changes in the stock market and economy in Q3 and address what's been top of mind for most investors and business owners: inflation.
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Hello. I’m Kurt Funderburg, Director of Equity and Economic Research for First American Bank’s Wealth Management group. Welcome to the third quarter 2021 edition of First American Bank’s Investment Insights.
Let’s dive right in.
The first estimate of third quarter 2021 GDP growth came in weaker than expected at 2.0% versus the 2.6% consensus estimate. This wasn’t too surprising since growth estimates had been falling steadily since August as challenges to the economy, including material shortages, labor shortages, transportation bottlenecks and high prices, mounted.
3q21 GDP growth decelerated from the 6.7% reported for this year’s second quarter, which itself was more than 1 and ½ percentage points below expectations.
Digging into the numbers, personal consumption expenditures, which account for around 70% of GDP rose 1.6%, the weakest performance since the depths of the COVID lockdown contraction in consumption during the second quarter of 2020. Consumption weakness was highlighted by a more than 9% drop in goods purchases – especially durable goods such as automobiles and appliances. The weakness in goods purchases stemmed from supply chain issues, price increases which led some consumers to delay purchases, and the wind down of federal pandemic fiscal support.
On a brighter note, services consumption rose nearly 8% on top of a more than 11% gain in the second quarter as the COVID delta variant failed to cause significant retrenchment among consumers.
Private investment recovered sharply from its second quarter slump as intellectual property investment (in things like computer software) offset declines in both residential housing and non-residential structures. Supply chain issues and inflation depressed housing as some families were priced out of the market or chose to wait for better conditions.
A drop in government expenditures was a drag on growth as emergency pandemic fiscal support declined.
Financial markets were mixed in the third quarter as investors worried about slowing domestic economic growth, higher interest rates, potential policy errors by the fed, inflation, government gridlock, economic weakness in China, and ongoing supply chain disruptions and shortages.
U.S. large cap equities were mixed as the S&P 500 achieved multiple new all-time highs but also experienced its first drawdown of at least 5% so far in 2021. As a reminder, on average, a drawdown of at least 10% happens once a year among U.S. large cap stocks. The S&P 500 managed a 0.6% gain for the quarter while the Dow Jones industrial average and Nasdaq composite both declined modestly. Broad international equity indices fell in the quarter with the emerging markets index down more than 8% on concerns over COVID outbreaks and slowing growth in China.
Most major domestic bond indices managed very slight gains for the quarter as the interest rate on the benchmark 10-year U.S. treasury bond fell early in the quarter before recovering those declines and a little more from early August through the end of September.
Now, let’s move on to our outlook for the fourth quarter and early 2022.
We see continued moderate growth for the U.S. economy in the fourth quarter despite ongoing challenges. Supply chain disruptions, labor shortages and inflation are among the primary headwinds that are likely to partially offset the still strong U.S. consumer and a return to the mobility and services demand patterns that prevailed prior to the pandemic.
Inflation has become more worrisome as it is now clear that elevated prices increase, fanned by shortages of labor and commodities, will persist into 2022 and perhaps beyond. Of specific concern is the energy shortage currently plaguing Europe and Asia which is impacting sectors as diverse as food production and transportation. Since energy markets are global in nature, the U.S. may not be able to completely dodge the impact of these mainly overseas shortages. While we expect some supply chain issues will begin to subside as we move into 2022, it is likely that many sectors will face challenges well into the new year and beyond.
Labor shortages, which have restrained the recovery so far this year, are likely to decline in severity but will still pose challenges for many businesses not the least of which will higher be wage pressures. One thing even higher wages may not fix is the 3 million baby boomers who chose to retire early during the pandemic, many taking extensive job knowledge and productivity with them.
Higher wages look set to contribute to ongoing inflationary pressures. The term transitory, favored by the Fed in referring to the current bout of inflation, now seems to indicate that higher prices will persist into next year if not beyond.
These inflationary pressures are feeding into investor worries about Fed policy. Investors widely expect that the Fed will very soon begin tapering or reducing the $120 billion per month of liquidity it has pumped into the economy through purchases of U.S. treasuries and mortgage-backed securities since the spring of 2020. However, the schedule for the central bank to begin raising its official policy rate of interest is more a matter of debate. Fed guidance calls for the rate lift off to begin sometime in 2023 but the bond market is predicting the Fed may be forced to raise rates in 2022, perhaps even twice, in order to keep inflation in check. Such a move could slow the economic recovery and dampen investor enthusiasm for stocks at a time when the buoyancy of financial markets plays a large role in the health and momentum of the economy.
In D.C., it looks like gradual progress is being made on infrastructure spending and President Biden’s socially ambitious budget proposal. It’s clear that whatever, if anything, makes it through Congress will be materially scaled back from the original proposals both as to spending and taxes. Of bigger concern on the government front is another looming battle late this year over raising the federal borrowing limit. The crisis of a potential default on U.S. treasury debt was averted last month with a stopgap debt ceiling agreement that only bought a couple of months of cushion. We anticipate a return to political brinksmanship in December before default is again avoided by kicking the debt can further down the road.
Last but not least on our list of concerns is China. Chinese property markets are in free fall after years of extensive over-building, speculation, and massive debt accumulation. We expect growth in the Chinese economy, which is more dependent on property markets than most developed economies, to continue to slow. The property crisis is on top of the energy shortage we mentioned earlier which is also restraining growth in China. Slowing growth in China potentially causes problems for many emerging market economies and even some developed market economies with large Chinese exposure.
On top of all that, Chinese/American relations continue to deteriorate, posing long-term risks to many U.S. Corporations for whom China is both an important market and important link in the supply chain.
In summary, the economy and financial markets face a variety of challenges as we move through the fourth quarter and into 2022. We continue to expect a moderate rebound in U.S. economic growth in the current quarter and think the odds remain favorable for modestly above trend growth next year. We believe that much of the anticipated growth that failed to materialize this year was mainly deferred rather than foregone.
We expect financial markets to remain volatile with a very modest upward bias to equity prices. Corporate earnings, while strong overall in the current third quarter reporting period could be vulnerable to inflationary pressures caused by shortages of inputs and higher labor costs. With real, after-inflation interest rates still solidly negative, we continue to believe that equities will provide superior long-term returns versus bonds despite occasional bouts of price volatility.
At First American Bank Wealth Management group we’re dealing with these uncertain times by continuing to tilt our portfolios toward high quality companies that have the resiliency and financial strength to thrive in varied market conditions.
As always, if you have questions about your investments, please contact your First American Bank Wealth Management advisor.
This has been the third quarter 2021 edition of First American Bank’s Investment Insights. Thank you for joining us and we look forward to speaking with you again soon.